By Philip van Doorn, MarketWatch
The annual stress tests will be different this year, as the Fed incorporates fallout from the coronavirus crisis in its analysis
Sell-side analysts have expressed confidence during the coronavirus crisis that most banks will be able to maintain their dividends through the expected economic recession. But now we're about to see the results of the Federal Reserve's annual stress-test process.
Analysts at Keefe, Bruyette and Woods don't expect any dividend cuts among the large U.S. banks undergoing the supervisory stress tests. They expect dividends to remain unchanged, and for all the stress-tested banks not to repurchase any shares until at least the end of 2020.
However, the analysts, led by Brian Kleinhanz, acknowledged in a report on May 26 that investors are concerned about the possibility of regulators requiring dividend cuts.
The analysts wrote that if the Fed were to make certain changes to its "severely adverse" stress-test scenario, detailed below, their dividend forecasts for Goldman Sachs Group Inc. (GS), Citigroup Inc. (C) and J.P. Morgan Chase & Co. (JPM) would be "at risk."
A two-part process
As part of the Dodd-Frank banking reform legislation that was signed into law by President Obama in 2010, large U.S. banks and intermediate holding companies of foreign banks that operate in the U.S. are subjected to annual regulatory stress tests to make sure they have enough capital to operate through a difficult recession without requiring bailouts.
There are actually two tests. First, the Dodd-Frank Act Stress Tests (DFAST) require large banks to run their own stress tests using the Federal Reserve's adverse economic scenarios for that year, and make the results public. The second part is the Comprehensive Capital Analysis and Review (CCAR), which is the Federal Reserve's process of testing banks' capital plans to make sure that the banks would still have adequate capital after planned share buybacks and dividend payments, under the adverse scenarios.
For the 2020 tests, 34 banks are subject to CCAR. You can see the full list here (). Banks were required to submit their capital plans by April 6.
In previous years, the CCAR results were announced after the DFAST results. This year, they will be announced at the same time. Last year, the Fed set its schedule for the announcements May 31. The regulator hasn't yet announced a schedule for this year. The KBW analysts expect the Fed to announce this year's schedule between May 29 and June 5, with actual stress-test results made public around June 25.
Problem with 'severely adverse' scenario
The Fed released the 2020 economic scenarios () for this year's stress tests in February. This was before it became clear that the coronavirus and consequent economic shutdown was likely to lead to a brutal recession.
The Fed's economic scenarios incorporate 28 variables, including measures of economic activity, interest rates, asset prices and volatility. They run from the first quarter of 2020 through the first quarter of 2023. The "severely adverse scenario" includes a "severe global recession," including U.S. unemployment peaking at 10%, an 8.5% decline in GDP from the pre-recession peak, three-month U.S. Treasury yields falling to near zero, and 10-year Treasury yields falling initially to 0.75%.
The unemployment rate shot up to 14.7% in April (), according to the Bureau of Labor Statistics, and it has probably gone considerably higher in May, as unemployment claims are processed.
The Federal Open Market Committee cut the federal funds rate twice during March to its current target range of zero to 0.25%. The yield on three-month U.S. Treasury bills is 0.12% and the yield on 10-year Treasury notes is 0.70%.
GDP shrank at an annualized pace of 4.8% during the first quarter (), according to an estimate from the Bureau of Economic Statistics. However, most of the Covid-19 shutdown has taken place during the second quarter, so the rate of GDP decline is probably headed higher.
With it being clear that the "severely adverse" scenario might be rosy when compared with the effect of the coronavirus, Federal Reserve Chairman for Supervision Randal Quarles said the following during a webcast on April 13, according to an American Banker () report: "The right thing for us to do is to continue our stress tests, but as part of them, to analyze how banks' portfolios are responding to real, current events, not just to the hypothetical event that we announced earlier this year."
How the Fed might augment stress tests
Kleinhanzl of KBW wrote in the May 26 report that if the Fed were to bake in a 20% increase in provisions for loan-loss reserves, while requiring a 50 basis-point buffer above the minimum required stress capital buffer (SCB), "we estimate that our dividend forecast for GS, C, and JPM would be too high."
So Kleinhanzl made it clear that he doesn't expect dividend cuts -- he expects Goldman, Citigroup and J.P. Morgan Chase to leave their dividends unchanged through the second quarter of 2022. But there is no way of knowing what approach the regulators have decided to take. Dividend cuts are possible.
Moving down to large regional banks, KBW analyst Brian Klock expects the group to be able to maintain its dividends through the end of 2020. But he also noted that investors are worried that the Fed might " 'reverse engineer' a common dividend cut by making the Covid-19 overlay to this year's DFAST extremely severe."
If that were to happen, and the Fed were to set a stress capital buffer higher than 5.13%, banks that would potentially be at risk of cutting dividends would include Citizens Financial Group Inc. (CFG), M&T Bank Corp. (MTB) Regions Financial Corp. (RF) and KeyCorp (KEY).
That said, Klock wrote: "In our view it is unlikely the Fed could support a Covid-19 overlay this harsh."
-Philip van Doorn; 415-439-6400; AskNewswires@dowjones.com
(END) Dow Jones Newswires
May 28, 2020 07:34 ET (11:34 GMT)
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